Archive for November 2010

I get frustrated when I read people arguing the Eurozone problem is that the ECB can’t come up with a one-size-fits-all policy stance. As if monetary policy is too tight for just a few small stragglers on the edge of Europe, comprising just a few percent of the Eurozone GDP. Actually money is even tighter in Europe than in the US. It’s too tight for every single Eurozone member. Nominal GDP is well below the levels of early 2008. Obviously in that situation many people, businesses and governments will have difficulty repaying their nominal debts. Look at the path of nominal income before the crisis (blue line); that’s the income trajectory that people and governments were expecting when they contracted their nominal debts.

Obviously several small countries made extremely foolish decisions. Greece faked its national accounts and Ireland agreed to bail out bank creditors. So they’d be facing some problems under the best of circumstances. But without the big drop in NGDP the Eurozone debt crisis would be far smaller, indeed would be relatively easily contained with a few bailouts.

How ironic it’d be if the ECB destroys the euro it was set up to protect, by obsessively trying to raise its value. They should have consulted King Midas.

Or perhaps Hayek, who warned what would happen if nominal incomes were allowed to decline.

HT: Thanks to Luis, and to Niklas Blanchard who finally taught me how to right-size graphs.

You’re probably getting sick of me arguing that the Fed should be talking about how it’s trying to raise national income, not the cost of living. Here’s Jim Hamilton making the same point:

The strength of this opposition [to QE2] may puzzle some within the FOMC. Traditionally, the Fed faced a trade-off between the goals of trying to keep both unemployment and inflation low. But at the moment, unemployment is painfully high by anybody’s standards, even as inflation is lower than the Fed feels is consistent with its goal of long-term price stability. Why is the Fed finding that persuading the public that inflation is too low is such a hard sell?

As Ben McCallum recently noted, regular Americans will tell you, of course inflation is still too high, because the price of X has gone up over the last year. Somehow the ability to process numbers that way fits naturally into our cerebral wiring, whereas averaging over all our purchases does not. There is also a deep-seated distrust of the official government measures of inflation. More fundamentally, many Americans think of inflation as an increase in the price of things they buy (which of course sounds bad), as opposed to an increase in the price of the things that they sell (which by itself is not that unpleasant). Perhaps the Fed should consider referring more to its desire to see wages and incomes growing more solidly, rather than its desire to see inflation higher.

In late 2008 when everyone was wringing their hands saying there’s nothing the Fed can do, Hamilton said something to the effect that; “If they can’t create inflation, let me have a shot at it. I’ll show them how.” (Not his exact words.) He was right then and he’s right now.

PS. Don’t say it would be deceptive advertising to switch from inflation to income. The Fed isn’t trying to boost inflation, they are trying to boost national income. For any given increase in NGDP they’d prefer to have less inflation and more real income growth. I’d be like a anorexic sumo wrestler saying he was targeting a higher fat level by eating big meals. No he’d be targeting more weight, and hoping that any weight gain is mostly muscle and only a little fat.

I’d love to see the looks on the faces of ad execs on Madison Avenue if Bernanke explained that he was trying to raise nominal spending and income, and thought the best way to communicate this fact to the public was by announcing the Fed was trying to raise the cost of living. A future satirist will have lots of fun picking over the wreckage of this crisis.

And that’s what those two little cute Bernanke bashing bears don’t seem to get. It’s not that the Fed is trying to prevent falling prices, or at least that’s not what they are most worried about when it comes to deflation. The price of iPhones, flat screens and other gadgets fall all the time, and that’s not a problem. The real thing that the Fed is worried about is wage deflation. When we all make less money we spend less, and it becomes even harder to pay back our debts. That’s an economic spiral that is very hard to get out of. And rising commodity prices make that spiral more likely, not less.

That’s slightly better than inflation, but still not really correct. The Fed doesn’t want higher wages, they want higher incomes. It is true that higher wages would be an indication that stimulus is working, but for any given increase in national income, higher wages mean fewer jobs. What we really need is more income.

It’s ironic that having to respond to those two little bears is making the intelligentsia come over to my side. My God! (pundit whacks hand on forehead) . . . it’s not inflation, it’s higher income that the Fed has actually wanted all along.

I’ve been asked to summarize my views on liquidity traps in one place, so brace yourself for a long post. (Longtime readers will definitely want to skip this one.)

For simplicity, I’ll define the term ‘liquidity trap’ as a situation where a fiat money central bank with a freely floating currency is unable to boost nominal spending because nominal interest rates have fallen to zero. There may be some cases where central banks are limited by laws regulating the sorts of assets they are allowed to purchase, but I know of no real world cases where that was a determining factor. Indeed I know of no case where a central bank that wished to boost inflation and/or NGDP was unable to do so. Nor do I think we need ever worry about that scenario actually occurring.

On the other hand, I do think the zero rate bound is a real problem for real world central banks. Because central banks are used to using short term rates as their primary policy tool, policy may well become sub-optimal once rates hit zero. But that would not be because an economy is “trapped” at a zero bound, rather it is because central banks are reluctant to aggressively use alternative policy tools, including tools that would be much superior to fed funds targeting even if the economy were not up against the zero bound.

Part 1. Basic monetary framework

Unlike most economists, I don’t believe that changes in short term interest rates play an important role in the monetary transmission mechanism. The liquidity effect is an epiphenomenon, having little impact on investment. Woodford argues that what really matters is changes in the expected future path of interest rates. I agree that policy expectations are a key, but find it more useful to think in terms of changes in the expected path of the supply and demand for base money. Simply put, I believe that current and expected future increases in base supply relative demand cause expected future NGDP to increase. This is because even if we are at the zero bound, and cash and T-bills are perfect substitutes, we are not expected to be there forever.

Increases in expected future NGDP (my preferred policy indicator) raise current asset prices (foreign exchange, stocks, commodities, commercial real estate, etc.) Because wages are sticky in the short run, production of corporate fixed assets, exports, commercial and residential real estate, commodities, etc, increase as their prices increase. The resulting higher real incomes also boost consumption. The reverse is true during tight money, as in late 2008.

I don’t like the interest rate transmission mechanism because interest rates often move in the “wrong” direction in response to monetary surprises. An unexpectedly small cut in the fed funds target in December 2007 sharply depressed equity prices at 2:15pm. The fed funds futures market confirmed that the decrease was smaller than expected. Keynesian theory says T-bond yields should have risen on the news. Instead, yields fell from 3 months to 30 years, as investors (correctly) understood that the Fed’s pathetic response to the sub-prime crisis would slow economic growth, and hence future fed funds rates would have to be cut sharply. (And they were in January 2008.) The action slowed the economy, but not because interest rates rose.

The powerful monetary stimulus of 1933 (dollar depreciation) had little effect on interest rates or the current money supply, but sharply raised future expected NGDP. This sharply raised current asset prices, and led to rapid growth in output.

If you buy my argument that changes in expected future NGDP (what Keynes probably meant by “business confidence”) is driving current asset prices and aggregate demand, then the next question is whether monetary policy can influence future expected NGDP at the zero bound.

Part 2. Unconventional policy tools.

My favorite example of an unconventional policy tool is the 1933 dollar devaluation. In 1932 the Fed had tried open market purchases to boost the money supply, but the policy failed as fears the US would be forced to devalue led to gold outflows, which negated most of the effect of the asset purchases. This is the only example of a liquidity trap cited in the General Theory. Unfortunately, Keynes confused two closely related problems. A liquidity trap is where an increase in the money supply fails to boost NGDP. In 1932 the constraints of the international gold standard meant that purchases of assets failed to substantially increase the money supply. That’s gold standard economics 101, having nothing to do with liquidity traps. As soon as we left the gold standard in March-April 1933, FDR was able to easily create rapid inflation despite 25% unemployment, near zero T-bill yields, and much of the banking system shutdown for many months.

FDR’s policy of raising the price of gold can be seen in one of two ways. In one sense it was a devaluation of the dollar in the forex markets, as most countries did not follow his action by raising their purchase price of gold. But even if the US had been a closed economy the Fed could have depreciated our currency by reducing the weight of gold in one dollar. In ancient times this was called “debasing coinage” and no one worried about the zero rate bound preventing central banks from inflating. As far back as 1694 John Locke used a reductio ad absurdum argument to criticize monetary ineffectiveness claims.

Another approach is to do quantitative easing. But printing money (even under a fiat money regime) will not be very effective unless the currency injections are expected to be permanent. Why would people bid up asset prices if the central bank was expected to pull the money out of circulation in the near future? This is why the QE done in Japan around 2003 did not do much, and it is why Paul Krugman is skeptical about QE. The other problem is that it is hard to make a credible promise to permanently increase the money supply by X%, because once you exit the zero rate bound the velocity of base money will rise sharply, and unless the base is reduced you will get hyperinflation. Markets know this, and hence don’t expect QE to be permanent.

The solution is to adopt an explicit nominal target such as the price level, or better yet NGDP, and then do level targeting. This is essentially a promise by the central bank to leave enough base money in circulation long term to allow for a modestly higher price level of NGDP. For instance, they might want to target 5% NGDP growth. Even if we are at the zero bound and monetary policy appears to be spinning its wheels, a commitment to higher future NGDP will tend to raise current AD.

The Fed made two mistakes. First, they did not engage in level targeting. It has long been understood that once nominal rates hit zero the central bank must adopt a level target. Indeed Bernanke lectured the Japanese on exactly this point back in 2003. So in September 2008 the Fed should have switched to level targeting, indicating that they wanted core inflation to grow along a 2% path until we were out of the recession, promising to later make up for any near-term shortfalls. Instead they allowed core inflation to fall well below 2%, and then (implicitly) indicated that they were going to continue inflation targeting, allowing bygones to be bygones. There was to be no above 2% inflation to catch up for the shortfall. This actually made their job much more difficult, as it resulted in a more severe recession than necessary in 2009, and then plunging investment pushed the Wicksellian equilibrium nominal rate below zero. They could no longer use their traditional policy instrument and they were reluctant to aggressively employ alternative measures, because they didn’t know how strong the effect would be. For instance, when banks needed more liquidity in late 2008 the Fed neutralized the effects of the large monetary base injections by paying interest on reserves at a rate higher than T-bill yields. Only when the recession drove stock prices to extremely low levels in March 2009, and deflation appeared on the horizon, was the Fed willing to do QE1. And only when the recovery faltered during mid-2010 (as European troubles increased the value of the dollar) was the Fed willing to do QE2.

The best way to avoid the zero rate bound is to create and subsidize trading in a price level or NGDP futures market, target the futures price, and let the money supply and interest rates respond endogenously. The Fed should be willing to supply an unlimited amount of reserves in order to keep NGDP futures prices rising along a 5% growth trajectory. Because there is no zero bound for NGDP futures prices, the Fed will always be able to keep NGDP expectations on target.

The flaw in the Keynesian model is that it assumes sticky wage and prices, whereas only T-bond prices are flexible. But there are lots of other asset prices that are also flexible, and that don’t have a zero lower bound. These include commodities like gold and silver, stocks, and foreign exchange. Unfortunately, all of those asset prices have drawbacks as targets for a major central bank like the Fed. And the asset price that would work best (NGDP futures prices) doesn’t yet exist.

[BTW, it’s a disgrace that the government has not yet set up and subsidized trading in a NGDP futures market. Contrary to popular impression the Fed isn’t trying to create more inflation; they are trying to create more NGDP. For any given increase in NGDP, the Fed would actually prefer less inflation and more RGDP growth. We desperately need a real time measure of market NGDP growth expectations in order to know whether AD is likely to exceed or fall short of the target.]

In this imperfect world the best the Fed can do is to focus on TIPS spreads as a crude measure of expected inflation, and a whole range of indicators for expected RGDP growth, such as the relative prices of stocks and commodities, as well as other indicators or real output trends. The Fed needs to do enough QE to increase expected NGDP growth (using all these imperfect indicators) up to the desired level. Since we are below trend, they should probably target slightly above 5% NGDP growth for a few years, then 5% thereafter.

Part 3. Fallacious arguments in favor of the liquidity trap

There are so many, I hardly know where to begin. One common argument is that swapping cash for zero interest T-bills is useless, because they are perfect substitutes. I don’t view them as perfect substitutes at all. When I get in the car to go shopping at Walmart I don’t think “Hmmm, should I take cash or T-bills.” At this point people will say “Yes, but zero interest bank reserves and T-bills are near perfect substitutes. And all the recent base injections are going into excess reserves.” Yes, but there is no zero lower bound on interest paid on reserves (and yes I’m including vault cash in “reserves.”)

But let’s suppose cash and T-bills were perfect substitutes. Even in that case a permanent injection of new base money would still be expected to raise the future level of NGDP, as liquidity traps don’t last forever. (If they did we should legalize counterfeiting.) Yes, a temporary currency injection wouldn’t do anything, but that’s almost equally true when rates on T-bills are positive. Temporary currency injections don’t matter, permanent ones do. It makes little difference whether rates are at zero or not.

The second fallacious argument is that monetary policy was ineffective in the Great Depression. Actually, when the government got serious about inflating they left the gold standard, and then they had no difficulty in raising prices sharply.

The third fallacious argument is that monetary stimulus would not be effective at the zero bound because central banks are conservative and no one would believe their promises to inflate. In fact, no one can provide an example of a central bank that tried to inflate but failed because they were stuck in a liquidity trap. Some cite Japan, but that example doesn’t meet any of the criteria for a liquidity trap:

1. The Bank of Japan has frequently expressed opposition to a positive inflation target. Because they are not trying to produce inflation, it’s no surprise they have failed to produce inflation.

2. It’s true that they pay lip service to avoiding deflation, but every time the inflation rate rises above zero percent they tighten monetary policy and go right back into deflation.

3. Some point to the large QE the BOJ did around 2003. But their promise to keep prices stable meant the QE was going to be temporary. The public knew this and quite rationally refused to bid up prices. Sure enough, when 1% inflation threatened to rear its ugly head in 2006, they promptly reduced the monetary base by 20%.

4. They passively sat by and allowed the yen to appreciate strongly, even as deflation was accelerating in recent years.

5. If it walks like a duck . . .

Some point to the alleged failure of the Fed to inflate, despite trying hard. Yet a few months back when Brad DeLong asked Bernanke why the Fed didn’t adopt a 3% inflation target, Bernanke said that would be a horrible idea. The Fed had worked so hard to bring inflation down to low levels. If you heard an answer like that, would you expect the Fed to produce higher inflation? It’s no surprise inflation expectations have remained low. Admittedly the Fed doesn’t want deflation either. My view is that when core inflation falls to about 1%, warning bells go off and the Fed grudgingly does some QE to boost inflation a bit closer to 2%. If that’s not what they are trying to do, I’d love to know their policy goal.

There’s another problem with the view that QE is ineffective at the zero bound. Even if the Fed couldn’t reduce nominal rates, they could always reduce real rates. Indeed Mishkin’s textbook suggests about 10 different transmission mechanisms other than nominal rates. Yet liquidity trap proponents ignore them all. Even worse, when the mechanisms are shown to work they go into denial, asserting that it just can’t be true because their theory says it’s impossible. So for instance during September and October there were more and more rumors of aggressive QE (and possibly even level targeting) emanating from various Fed officials. Mishkin’s text says this should boost stock prices, it should depreciate the dollar, it should raise commodity prices, it should raise inflation expectations in the TIPS markets, and it should lower real interest rates. And all of those things happened. For years Paul Krugman has been arguing that what the Fed really needed to do was to raise inflation expectation. Well they did it. And his response seemed to be incredulity, as if the markets were nuts in thinking QE could actually raise inflation expectations.

Although Krugman and Robert Barro are poles apart ideologically, they both suffer from one weakness–relying too much on what their models tell them. Both expressed skepticism about whether QE would do very much, because they looked at QE from a mechanistic perspective. But QE is much more than that; it is an implicit commitment by the Fed to seek (slightly) higher inflation. Of course they need to do much more, but they did succeed in terms of their very conservative goals. They did generate about 0.5% higher inflation expectations over 5 years. The reason QE worked was not the operation itself (which I agree does little or nothing) but rather because it tells the market that the Fed is now more serious about boosting long term prices and NGDP. In other words they are now willing to leave that base money out there long enough to get closer to their implicit inflation target. The Fed was afraid to directly call for higher inflation (something Krugman thinks could work) so they spoke in code, hoping the markets would understand them but Sarah Palin would not. Unfortunately for Bernanke, Sarah Palin has advisers who know exactly what the Fed was up to.

Part 4. Reductio ad absurdum arguments

I can’t take anyone serious who actually believes in a complete liquidity trap–i.e. that no amount of monetary base injections would be inflationary. Taken literally, that would imply the Fed could buy up all of Planet Earth without creating any inflation. Among serious economists the debate is over magnitudes. The skeptics will say that the amount of QE required would be unacceptable, it would expose the Fed to excessive risks if they later had to resell assets in order to prevent runaway inflation.

In fact, there are all sorts of reasons why this “risk” argument is bogus. First of all, the high base demand is itself a product of the Fed’s contractionary policies, which allowed NGDP to fall in 2009 at the sharpest rate since 1938. That’s why banks hoard reserves. A much more aggressive monetary policy would mean less real demand for base money. Second, the demand for base money has been artificially bloated by the IOR policy; the public is not hoarding much cash and they certainly would not do so if the Fed set a much higher inflation or NGDP target path. Most importantly, any capital losses suffered by the Fed would be tiny compared to the gains the Treasury would get from much faster NGDP growth. Remember that the big drop in NGDP is the number one reason the deficit ballooned in 2009—more important than even the fiscal stimulus. Furthermore, many of the Fed’s purchases have been medium term T-notes, for which price risk is not that significant. If people are actually worried about this issue, the Fed could buy equities and foreign bonds, which would appreciate with an expansionary monetary policy. But in my view those (controversial) steps would not be necessary, as the risks are greatly overblown.

Maybe I should stop there—I feel like I am beating a dead horse. Does anyone still believe in liquidity traps? Is there even anyone still reading this post?

This post is partly in response to a long conversation I’ve been having with Rodney Everson. He appears to be the first person to mention the negative interest rate on reserves idea, but I am less enthused about his argument that raising the fed funds target above zero can actually be expansionary:

Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.” If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph. You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.

It is true that a zero fed funds rate promotes massive hoarding of base money, and also that base money hoarding is, ceteris paribus, highly contractionary. But the Fed cannot solve this problem by raising the fed funds target. Markets would interpret that action as being contractionary, as a signal that the Fed plans to withdraw funds to make the new target stick.

How can we reconcile the following two facts:

1. Near-zero short term rates are almost always associated with disinflation and low output, not a booming economy.

2. In the short run, a cut in the fed funds rate target is an expansionary action.

The answer is that (as Milton Friedman said in 1997) near-zero rates are a sign that money has been tight.

So how do we solve this problem? Some Keynesians argue that we need to promise to hold rates near zero for an extended period. But that’s not really a satisfactory answer. The Japanese case shows that an extended period of near-zero rates may accomplish nothing; rather it may simply reflect a period of continual NGDP stagnation.

Instead, the Fed needs to raise inflation using a different policy tool, some tool other than the fed funds target. This might involve QE, or it might involve cutting the IOR, perhaps to negative levels. Or it might involve a target rate for the trade-weighted exchange rate. But the best option is to use level targeting as a policy tool. Set a much higher price level or NGDP target trajectory than the market currently expects, and then promise to make up for any future shortfalls.

Higher rates are associated with prosperity. But we can’t get to prosperity by having the Fed raise rates. The Fed must use other steps to raise NGDP growth expectations so high that the Fed will need to raise the fed funds target in order to prevent the economy from overshooting its target. We need to whip the horse so hard that we need to pull back on the reins to keep it from running too fast. But pulling back on the reins, by itself, will simply slow the horse down.

We don’t need higher short term rates right now, we need to do other things that will result in the Fed needing to raise short term rates in the future. And the sooner the Fed needs to raise short term rates the better. Promising to hold rates near zero for an extended period is not that answer, as the Japanese have learned over the past 15 years.

PS. Would my grammar teacher have approved of the phrase “need to need?”

PPS. I’m actually not that far from Everson, if the Fed did the right thing with its other policy tools then it would soon be able to raise the fed funds target a bit above zero.

“We didn’t actually, I think, do what Franklin Delano Roosevelt did, which was basically wait for six months until the thing had gotten so bad that it became an easier sell politically because we thought that was irresponsible. We had to act quickly.”

As Ferguson explains, this is a right-wing smear. What actually happened was that during the interregnum between the 1932 election and the1933 inauguration “” which was much longer then, because the inauguration didn’t take place until March “” Herbert Hoover tried to rope FDR into maintaining his policies, including rigid adherence to the gold standard and fiscal austerity. FDR declined to be part of this.

But Obama buys the right-wing smear.

I’m not a FDR hater; I think he was “magnificently right” to devalue the dollar (to quote Keynes.) But FDR probably should have cooperated with Hoover–even if it meant (falsely) promising not to devalue the dollar.

The Democratic Party solemnly promises by appropriate action to put into effect the principles, policies, and reforms herein advocated, and to eradicate the policies, methods, and practices herein condemned. We advocate an immediate and drastic reduction of governmental expenditures by abolishing useless commissions and offices, consolidating departments and bureaus, and eliminating extravagance to accomplish a saving of not less than twenty-five per cent in the cost of the Federal Government. And we call upon the Democratic Party in the states to make a zealous effort to achieve a proportionate result.

We favor maintenance of the national credit by a federal budget annually balanced on the basis of accurate executive estimates within revenues, raised by a system of taxation levied on the principle of ability to pay.

We advocate a sound currency to be preserved at all hazards and an international monetary conference called on the invitation of our government to consider the rehabilitation of silver and related questions.

Politicians lie all the time. They are expected to lie. The British government lied in 1931, 1967, and 1992, when it said it wasn’t going to devalue, before it did devalue. That’s expected. Everyone knows that if you say you will devalue in the future, it forces an immediate devaluation. And under a gold standard if there is uncertainty about whether a devaluation will occur then gold hoarding increases, which is deflationary. This happened on four occasions during the Great Depression, and on each occasion asset prices and industrial production declined sharply.

FDR basically had three choices. The traditional route would have been to lie and say that he would adhere to the platform, maintaining the gold standard while working toward an international agreement to give silver a monetary role. The markets knew that other countries weren’t going to adopt silver. Then when he took office he could have said; “Because I wasn’t able to get agreement, we have to go it alone with a currency devaluation.”

Or he could have told the truth and said he was going to devalue the dollar. That would have forced Hoover’s hand, and a devaluation would have occurred almost immediately. The promising upswing of July to October 1932 would have turned into an explosive boom. The 57% increase in industrial production that occurred during the first four months of FDR’s term would have instead occurred in the last 4 months of the Hoover administration. If FDR had gone ahead with the NIRA’s high wage policy then he would have been blamed for aborting the Hoover recovery.

Instead he was continually evasive. Even in Hoover’s last days in office he refused to support any of Hoover’s actions to address the banking crisis.

The interregnum was a horrible period, with an enormous amount of suffering during the winter of 1932-33. It was the low point of the Great Depression. And although the Depression itself was Hoover’s fault, this especially bleak period was partly FDR’s fault. I’m not one of those conspiracy buffs who thinks FDR intentionally allowed Pearl Harbor to happen. And I doubt he fully understood the effect of his evasive answers. But most educated observers back then knew what was going on. They knew that uncertainty about the dollar was depressing the economy. The press pointed to similar events during the late 1800s, when fears about the soundness of the dollar had also had a deflationary impact. FDR had three options, and he picked the one that imposed maximum harm on the economy. That’s no right wing smear, it’s the truth.

Update: Commenter Russ Anderson pointed out that this post was confusing. I should have been clearer that while the best option for the country was for FDR to state he would devalue, and force Hoover’s hand, that option was a complete non-starter, politically unacceptable. Those things just are done. Given that the best option wasn’t really on the table, he should have said he’d maintain the gold standard. Nothing I said should be seen as implying that the Great Contraction was caused by anyone other than Hoover.

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.